Annuities explained, the guaranteed annuity

A conventional annuity is a contract whereby the insurance company agrees to pay to the investor a guaranteed income either for a specific period or for the rest of his or her life in return for a capital sum. With a guaranteed annuity, income is paid for the annuitant's life, but in the event of early death within a guaranteed period, the income is paid for the balance of the guaranteed annuity period to the beneficiaries.

The capital is non-returnable and hence the income paid is relatively high.

Annuity key points

Income paid is based on the investor's age, i.e. the mortality factor and interest rates on long term gilts.

Income is paid annually, half yearly, quarterly or monthly.

Annuities can be on one life or two. If they are on two lives the annuity will normally continue until the death of the second life.

If the annuitant dies early, some or all, of the capital is lost. Capital protected annuities return the balance of the capital on early death.

Payments from pension annuities are taxed as income.

Purchased life annuities have a capital and interest element - the capital element is tax free, the interest element is taxable.

Types of annuity

Types of annuity include the following - Immediate; guaranteed; compulsory purchase; open market option; deferred; temporary; level; increasing or escalating.

Immediate annuity

The purchase price is paid to the insurance company and the income starts immediately and is paid for the lifetime of the annuitant.

Guaranteed annuity

Income is paid for the annuitant's life, but in the event of early death within a guaranteed period, say five or 10 years, the income is paid for the balance of the guaranteed period to the beneficiaries.

Compulsory purchase

Also known as open market option annuities, these are bought with the proceeds of pension funds. A fund from an occupational scheme or buy-out (S32) policy will buy a compulsory purchase annuity. A fund from a retirement annuity or personal pension will buy an option market option annuity - an opportunity to move the fund to a provider offering better annuity rates.

Deferred annuities

A single payment or regular payments are made to an insurance company, but payment of the income does not start for some months or years. This may be suitable for an investor funding for retirement or school fees.

Annuity certain/deferred annuity certain

Often used for school fees purposes. The annuity is paid for a fixed period either immediately or after a deferred period, irrespective of the survival of the original annuitant.

Temporary annuity

A lump sum payment is made to the insurance company, and income starts immediately, but it is only for a limited period - say five years. Payments finish at the end of the fixed period or on earlier death.

Level annuity

The income is level at all times. This of course does not keep pace with inflation.

Increasing or escalating annuity

The annuitant selects a rate of increase and the income will rise each year by the chosen percentage. Some life offices now offer an annuity where the performance is linked to some extent to either a unit linked or with profits fund to give exposure to equities and hopefully increase returns.